The yen's rally faces a test: Ongoing policy divergence requires more hawkish guidance to continue momentum.

(1) The yen's rally is becoming difficult to sustain: the market has already priced in a rate hike by the Bank of Japan this week, while the Federal Reserve's tightening cycle is still slightly ahead of the Bank of Japan's before the end of the year. Although the yen has risen to its highest level since February, the one-year forward USD/JPY OIS spread has rebounded to around 2.5%, and the implied policy divergence is challenging the yen's momentum. This week's policy meetings will test whether this divergence can persist. (2) The OIS market shows there is about an 85% probability of the Federal Reserve raising rates by 25 basis points on September 16, and a relatively high probability of a cumulative 50 basis point hike by the end of the year; the market has almost fully priced in a Bank of Japan rate hike on September 18, but only assigns a 25% probability of another hike in October, even though the Bank of Japan is expected to cumulatively raise rates by nearly 50 basis points by year-end. Therefore, the market expects the Federal Reserve's tightening to slightly outpace the Bank of Japan before the end of the year, but is far from pricing in consecutive rate hikes by the Bank of Japan. (3) Currently, the yen's exchange rate seems to be reflecting expectations of an increasingly aggressive Bank of Japan policy normalization path, which is stronger than the pricing in the rates market. To sustain the recent rise, not only is a rate hike needed this week, but also sufficiently hawkish policy guidance that makes consecutive hikes possible and narrows the expected US-Japan policy gap; otherwise, a widening policy gap may expose the yen to downside risk.